A controversial series of articles criticising the asset management industry’s approach to sustainable investing, authored by Blackrock’s former sustainable investing chief, Tariq Fancy, has thrown into question the efficacy of the environmental, social
and governance (ESG) movement. As would be expected, the salad of responses to Fancy’s position have ranged from outright objection to complete alignment. Distilling Fancy’s argument into
nine key claims, US financial commentator at the
Financial Times, Robert Armstrong, falls into the latter of these allegiances.
To assume its own position in the debate, Finextra – alongside founder of Responsible Risk, and contributing editor to Finextra Research, Richard Peers – has turned to a network of industry experts to get their take on whether ESG is indeed a “dangerous
placebo”. The position put forward by these interviews was nuanced: while Fancy does well to highlight areas of sustainable finance that need renovating, his somewhat myopic perspective fails to consider ESG’s full range of attributes, and appreciate where
its value lies.
With the United Nations’ COP26 conference in Glasgow upon us, it is time to revive Finextra’s sustainable finance mythbuster series and set the record straight on some sustainable finance falsehoods.
This instalment, part one, addresses Fancy’s claims 1-4, and puts forward the industry experts’ rebuttals. Part two will speak to claims 5-9.
Claim 1:
ESG investing, if it changes the world, does so by affecting the cost of capital. That implies ESG investors can expect lower returns, but the ESG industry disingenuously promises outperformance.
In an interview with Finextra, Eoin Murray, head of investment, Federated Hermes, shared some of Fancy’s unease. He noted that the fact this needs to be highlighted at all is symptomatic of some of the industry’s exaggerated claims.
“No, the asset management industry alone is not going to save the world,” he conceded. “But, as a provider and intermediary of capital, it does have a major role to play. The key lies in its role as
stewards of capital.” Indeed, systematic change will only take shape with concerted, ‘top-down’ action from governments, regulators, central banks, and trade associations – as well as ‘bottom-up’ efforts by investors, and perhaps to a lesser extent,
individuals.
But is the promise of outperformance truly disingenuous? While it is possible to identify periods where ESG investing outperformed the market, investors can draw the opposite conclusion by pulling out a particular data range. It really depends on the timeframes
you look at, explained Maya Hennerkes, associate director, ESG sector lead for financial intermediaries, European Bank for Reconstruction and Development (EBRD). Contrary to
this Institutional Investor article, “academia is largely supportive of ESG’s profitability in the long-term,” she said.
“It also varies by geography. An emerging or developing market will be more profitable because you can more easily set yourself apart with a robust management approach.”
Performance considerations should centre on a more important point, such as historically, the market has not priced in areas that ESG investing is most concerned with, Murray added. Overlooking that point has occasionally had disastrous effects. This new
mindset in investment management should therefore be welcomed, as it means incorporating more externalities into decision-making.
In order to overcome false expectations about performance, more transparency and consensus over what is meant by ESG investing, is needed.
Rebuttal: ESG investing is not the only answer to the global challenges that face us – the sector must work to soften any such disingenuous claims. It has, however, been shown to outperform in a number of scenarios.
Claim 2:
If ESG investing does provide higher returns, then we can just call it ‘investing’, and it changes nothing.
One of the investment management industry’s aims is indeed to deliver returns to investors. The ESG space, however, has a unique role to play in serving investors that want to see their money both ‘do well’ and ‘do good’. While there are some asset managers
who opt for a quick sale in a hot market, Murray pointed out, some do not take such a superficial approach – and consider factors beyond short-term gain. The ‘ESG’ label, as such, has utility in greasing the wheels of environmental, social and governance action
– providing we can overcome the greenwashing problem.
“It’s a subtle but very important point that Fancy and Armstrong haven’t acknowledged,” noted Murray. “It is not hubris that drives ESG investing – rather, it is investors who demand solutions that deliver returns and effect positive change in the industry.”
When looking beyond simply constructed ESG equity index exchange traded funds (ETFs), there is ample opportunity to receive returns while supporting positive change. “We want to direct capital to the companies run by those with vision, who manage risks by
addressing the challenges of a changing world, and steer capex toward shifting in the value chain in a way that benefits society,” commented Murray. “Our engagement with corporates encourages and emboldens these entities.”
Rebuttal: ESG offers investors returns as well as access to, for instance, climate change solutions. The challenge for the asset management industry is to deliver on each of these abilities, while being transparent about its limitations.
Claim 3:
The biggest problems ESG investors claim to tackle have time horizons much longer than any investor, so purpose and profit rarely overlap where it matters most.
The idea that ESG concerns are only relevant in the long-term is, arguably, one of Fancy’s most damaging assertions. As those that fell victim to recent climate change-induced disasters – such as the floods in Germany and China, or the wildfires in Greece
and north-western USA – would attest, the environmental crisis is very much in our laps.
“Insurance premium adjustments to reflect increased risk of flooding and sea level rise, changing consumer preferences, a rapidly changing labour market and regulatory requirements to mitigate climate change are all short-term risks that need to be priced
in now,” Murray pointed out.
Aside from insurance costs, other immediate ESG-related challenges can also impact operational continuity and financial performance – leading to legal, operational, and reputational damage. Labour risks (such as those induced by the pandemic), human rights
violations, environmental spills and pollution accidents are just some examples.
However, the climate crisis – as Fancy rightly reports – will also impact us in the long-term. The financial sector must make it clear how it will address this challenge.
“It’s true that markets tend to operate on a short-term time horizon, whereas long-run societal challenges like climate change and inequality won’t necessarily affect the price of a stock today,” said Murray. “But, for institutional investors that invest
for the long term, those challenges could well affect a stock’s price over their horizon.” As such, ESG investing is the right approach for them, precisely because it looks at horizons they care about – not quarterly periods, but a decade plus.
Rebuttal: The time horizon tension is one that is being acknowledged and addressed by the industry today.
Investors can have a role to play in tackling the immediate ESG-related issues, facing the world today. What’s more, purpose and profit can overlap in decade-plus periods. Clearly, investors are aligned with ESG issues – the markets, unfortunately, have
some catching up to do.
Claim 4:
The core mechanism of ESG investing is divestment, but when an investor sells a security in the secondary market, another buys. All the ESG selling may drive down the price at which the buyers buy, giving them an opportunity for juicy returns as the price
recovers.
Asset managers can do more to influence change than simply reallocating capital. Capital allocation is, arguably, the sole purview of the primary markets and the banks. By exercising stewardship through their influence and powers as shareholders and bond
owners, investment managers are better placed to effect positive change than simply by divesting. Again, it all comes down to raising the cost of capital for ‘bad’ companies, so they have less financing to do ‘bad’ things.
“Investors understand the difference between investments that lack substance in sustainability versus those that have proprietary approaches and are process-driven, with a strong record of delivery,” argued Murray. “Their due diligence allows them to allocate
capital appropriately to managers with genuine skill in this area.”
Divestment, meanwhile – which Fancy and Armstrong wholesale brand the mechanism of ESG investing – is risky, because it means somebody else could pick up the name, noted Murray. This aligns with
Fancy’s argument that there is a difference between excusing yourself of something you do not wish to partake in and actively fighting against something you think needs to stop for
everyone’s sake.
Worse still, divestment means the company in question could end up in private hands or nationalised – potentially being managed to maximise profits, with little regard for ESG impact. Recently, the Middle East provided us with a compelling case study on
what can happen when organisations fall into national hands. The assets of large oil companies were sold to local governments, which proved less aligned than an ESG-minded institutional investor might have been. In this sense then, divestment can have a real-world
impact.
Hennerkes, on the other hand, was less critical of divestment as a strategy, and argued that private owners and national governments should not be – by definition – considered adverse to the ESG movement. Making a general decision which sectors not to support
(such as fossil fuels) is a justifiable decision for any investor who makes allocation decisions following its own sustainability goals, she argued. So, while divestment is not a silver bullet, it makes access to capital more difficult for ‘dirty’ industries
and shifts the availability of funding to more sustainable ones.
As for the private equity sector, Hennerkes sees “a lot of positive dynamics and funds in it for the longer term. They have seven, eight, sometimes 10-year horizons, and work directly with the companies that they invest in”.
This is self-evident – today’s private equity conferences have evolved from holding a single ESG panel, to discussing in depth the Sustainable Finance Disclosure Regulation (SFDR), taxonomies, and reporting. Hennerkes, for her part, works with around 120
private equity clients, who are generally keen to integrate ESG considerations. “The private equity industry has realised that if they want to fundraise via international finance institutions or institutional investors, they need to have a good ESG plan,”
she said.
Generally speaking then, divestment should only be one aspect of a more holistic strategy, which includes stewardship and robust ESG risk management. Likewise, the importance of engagement cannot be understated. For corporate activity to respond to the world’s
biggest challenges, asset managers must be transparent, use their voices as stakeholders to raise ESG concerns, and encourage firms to come up with a transitional plan.
Federated Hermes, for its part, is increasing transparency by publishing investment rationales for areas that could be considered controversial. An accompanying engagement plan will explain to investors why, for instance,
TotalEnergies is being held. In the case of the French oil company, it is undergoing a green rebrand, and has a significant portfolio of hydrogen patents. “We need to encourage more companies like this to continue down that route,” Murray said.
Rebuttal: While development thus far has been slow and limited, the ability of investors to reward companies for changing their strategy and delivering specific outcomes is invaluable. That said, stewardship is only one tool in the toolbox. It is only
powerful where investors have significant influence. Other ESG strategies need to be applied.
In defence of ESG
The impact of Fancy’s claims is already having real-world repercussions. It has encouraged a number of managers to alter their labelling of funds and is forcing players to be more honest.
The holes Fancy picks in ESG investing, however, aren’t being illuminated in the hope they will be filled. They are being used as a means to shoot the entire sector down. While it has been around for years, ESG investing only recently emerged as the darling
of the asset management industry – muscling its way from the margins of the global investing conversation to the centre. It remains a highly complex beast, and as such, needs to be nurtured, and given time to sharpen its teeth. ESG investing can consist of
many different strategies, from simple exclusion lists to sophisticated ESG risk management and allocation frameworks, and not all are equally effective. Therefore, rather than discrediting “ESG investing” as such, a critical view under the surface is needed
to identify what strategies are applied in each case.
None of this changes the fact that solving the planet’s toughest issues cannot happen through investment managers alone. Capital markets do not exist in a vacuum. The challenges we face are systemic, and therefore require a co-ordinated response from the
entire ecosystem. If Finextra’s interviews could be distilled into a single upshot, it would be that a trifecta of engagement, capital reallocation, and regulatory change is required to mount a comprehensive counterattack against ESG risks.
It is rare, however, that regulation comes without unintended consequences. The financial industry must get behind its own version of what changes are required. The beauty of the industry is that it can take a non-political stance.
Generally speaking, Fancy and Armstrong’s novel brand of ESG scepticism has served to shine a light into the darkest corners of ESG but fails to recognise just how sophisticated sustainable investment has become today.
Stay tuned for part 2 of this mythbuster series, where we dissect Fancy’s claims 5-9.